Earnouts in M&A Transactions Performance-Based Deal Structures

Many of the advantages from the buyer’s point of view are not advantageous to the seller of the business. The seller will have a different perspective concerning the earnout agreement. An earnout means they pay less up front and therefore have to borrow less money at the higher interest rates. This is often a strategy that buyers employ in times when interest rates are higher than normal.

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Regions like Europe may see a larger uptick if economic sentiment improves, and emerging markets (e.g. India, the Middle East) are on the radar for more cross-border acquisitions. Energy and industrials are predicted to stay active, continuing the consolidation trend as companies transition portfolios for the future. Another emerging trend is the increasing complexity and length of deal processes in the current environment.

Interest in areas like AI, cloud, and semiconductors could drive new deals. First, there has been a cooling of mega-deals in certain high-growth sectors and a rise in strategic deals in others. Over the past few years, technology deals went from boom to relative bust. The number of deals over $1B rose by 17% in 2024, along with an increase in their average value. Despite this, some regions (notably the US) and sectors (energy, certain healthcare deals) showed resilience even as overall totals were down. The Technology, Media, and Telecommunications (TMT) sector follows with 114,443 deals.

• The structure can help bridge the gap when there’s a mismatch in valuation between the buyer’s offer and the seller’s expectations.
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• The inability to successfully integrate the newly acquired company into the buyer’s business operations may adversely affect performance, making it more difficult to meet earnout objectives.
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• Different earnout structures address specific business objectives and risk profiles
• Valuation gaps can be the Achilles’ heel of a deal – they’re often born out of differing views on the company’s future earnings potential or from unforeseen market risks.

Choosing Earn-Out Targets

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Applying this standard, the court found no evidence that the buyer breached its obligation to use commercially best efforts. It is essential to involve not only in-house and outside legal counsel but also the business team, accountants and tax advisors. Parties should set out standards for determining milestone achievement and measurement of metrics of the earn-out terms that do not leave room for subjective interpretation. If milestones are not clearly defined, however, the parties may end up disputing whether or not a milestone was achieved.

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Some agreements allow for catch-up provisions if targets are missed one year but exceeded the next. The amount can be a flat sum per period, a formula based on how much the target surpasses a threshold, or a percentage of performance. Earn-out payments can be structured as a single payout at the end of the earn-out period or multiple payments at regular intervals. Financial targets are common but tend to be more susceptible to accounting interpretations and manipulation.

So, they hire fewer members of the seller’s team and for less time. On the other hand, strategic buyers are operators themselves and they therefore often believe they’re already well-supplied with management talent and admin support. (See The Cause of Most Bad Deals for more reasons why deals go bad.)

• Last year’s earnout incidence is particularly notable given the overall drop in dealmaking.
• The buyer should maintain a record of business justifications for actions taken during the earn-out period that could impact payments.
• Incorporate robust legal language, conduct thorough diligence, and engage in open and honest dialogue to construct an earn-out that’s a win-win for both buyer and seller.
• Disputes often rest on different assumptions and perceptions about what the business was before the sale, and what the combined business is today.
• The buyer can use an earnout to tie the seller to the business, ensuring they won’t walk away entirely and leave the buyer with a business they don’t know how to run.
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Almost all PEGs offer selling managers the opportunity to buy equity in their target company for the same price the PEG paid (“roll-over” equity). We hope that you’ve found this article valuable when it comes to learning what an earnout is in the M&A process – thanks for reading! Earnouts are a powerful and popular tool in M&A transactions that help bridge valuation gaps and move deals forward. However, these deals can take several different forms. Let’s explore a quick example of how an earnout works…

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Strategic pivots, market exits, or significant investment changes could impact earnout metrics in ways that create conflicts with sellers. Ongoing earnout calculations require dedicated resources, sophisticated accounting procedures, and regular communication with sellers. From a buyer’s perspective, earnouts offer compelling advantages while introducing specific risks that require careful management. Performance monitoring requires ongoing collaboration between buyers and sellers. Usually, the buyer’s and the seller’s accountants will be heavily involved to make sure that both parties calculate the performance metrics in the same way. These might include the target company’s historical financial performance, market conditions, and realistic growth projections.

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Each software business is unique, much like every founder’s journey. Let us say the target that needs to be achieved is 30% revenue growth year-over-year for the next two years. This is a common challenge faced by businesses exploring a sale.

However, the real underlying issue is that the buyer doesn’t think the company is worth $75 million and doesn’t believe they can scale to $100 million in the next 5 to 10 years. As our example, say Company earnout data from m&a deals A, a consulting business, has revenue of $25 million and earnings of $7.5 million. This section is designed to give you an understanding of how an earnout works in an M&A transaction through an example. When the earnout is made contingent upon something, that condition needs to be met in order for the earnout recipients to be paid. Third, we have what the earnout agreement is contingent upon.

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